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De Grauwe Supply or Demand CEPS Commentary 2014
De Grauwe Supply or Demand CEPS Commentary 2014
T
he recent conversion of François Hollande to supply-side economics is surprising. It
makes the victory of the northern European policy-makers who believe that
insufficient aggregate demand should be fought exclusively by supply-side measures
complete. As I will argue, it is not the first time in post-war history that economists and
policy-makers fight a problem by applying the wrong medicine; or to put it differently, it’s
akin to some generals who fight a new war by applying the strategies developed for the
previous war.
1Orphanides(2001) analysed how the US Federal Reserve misinterpreted the decline in output in the
1970s.
Paul De Grauwe is John Paulson Professor in European Political Economy at the London School of
Economics and Associate Senior Research Fellow at CEPS. He gratefully acknowledges valuable
comments from Daniel Gros and Karel Lannoo.
CEPS Commentaries offer concise, policy-oriented insights into topical issues in European affairs.
The views expressed are attributable only to the author in a personal capacity and not to any
institution with which he is associated.
Available for free downloading from the CEPS website (www.ceps.eu) © CEPS 2014
Centre for European Policy Studies ▪ Place du Congrès 1 ▪ B-1000 Brussels ▪ Tel: (32.2) 229.39.11 ▪
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2 | PAUL DE GRAUWE
This policy reaction created a double problem. First as the source of the shock was on the
supply side and involved a decline in productive capacity, a demand stimulus could not
really correct for this decline. This then led to the second and most spectacular problem. In
the face of rigidity in supply, the demand stimulus led to a price-wage spiral and high
inflation. Nothing discredited the Keynesian-inspired aggregate demand models more than
the explosion of inflation that followed the ill-advised policy reaction of demand expansion.
2 These models are general equilibrium models. As a result, they also model the demand side.
However, it is fair to state that these models focus on the supply side by stressing the importance of
technological shocks in triggering business-cycle fluctuations. In addition, these models use the
representative agent assumption. Thus the demand side is modelled as a problem of a single
representative consumer maximising his inter-temporal utility. Since this representative consumer
cannot make systematic errors, there is no reason why an outsider like the government should try to
correct for the decision of the optimising consumer.
YES, IT’S THE ECONOMY, STUPID, BUT IS IT DEMAND OR SUPPLY? | 3
created in the eurozone. None of these central bankers thought of applying flexibility to their
own market and to cutting their own wages.
Five years after the negative demand shock of 2008-09, policy-makers continue to
misdiagnose the nature of that shock. Now the French President François Hollande has
joined the crowd of European policy-makers who strongly believe that supply-side measures
are all that matters in Europe and that such measures will automatically lead to solving an
insufficiency of demand. This is a surprising change of strategy especially now that, for at
least one year, the rate of inflation in Europe, and especially in the eurozone, is declining
continuously. In early 2014, it reached 0.8%. If the shock had come from the supply side, one
would have observed an increase in inflation, very much like in the 1970s when the
European and American economies were hit by a negative supply shock.
References
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